Earlier this week,
the flagship S&P 500 stock index (SPX) officially entered
bear-market territory. As it edged past a 20% loss since its
all-time high of October 2007, all debate about whether or not a
bear really exists was instantly rendered irrelevant. Beyond any
doubt we now sojourn in a full-on bear market!

The fearsome
reputations of stock bears are well-deserved. During the legendary
bear running between January 1973 and October 1974, the SPX lost a
sickening 48.2% of its value. In a much more recent specimen,
between March 2000 and October 2002 the SPX shed 49.1%. Cyclical
bear markets often tend to cut stock prices in half by the
time they fully run their courses!

While these raw
numbers alone are frightening, realize this is across the entire
broader markets. The 500 biggest and best companies in the US
comprise the S&P 500. They are involved in 9 major sectors and a
myriad of actual businesses. They are the investment-grade elites,
the blue chips. Even these companies, all the giants whose names
you know, can easily see their stock prices halved during a
bear.

So needless to
say, bears are exceedingly dangerous environments for investors.
Fools ignore bears at their own great peril, and even the prudent
are filled with plenty of trepidation. For the most part, you can’t
merely weather a bear by buying the best-of-breed companies. They
will get sucked into the selling too. Other than sitting in cash,
the only viable strategy for surviving, even thriving, in bears is
actively trading these merciless beasts.

And it can
be done. Back in 2002, the last cyclical-bear year until 2008, the
SPX fell 23.4%. It was an exceedingly terrible year for the stock
markets, a time of much wailing and gnashing of teeth. Yet the
stock trades we realized that year from our
Zeal Intelligence
newsletter trading recommendations averaged 40.5% absolute gains.
And since we held these for less than 4 months each on average, we
were growing our capital at a 129.1% annualized rate. Bear be
damned, it was a great year!

The key to
successfully trading bear markets is understanding their primary
driver, sentiment. The mission of a bear is to gradually hammer on
investors until their perceptions of stocks radically change. When
a bear begins, optimism and greed abound and traders are far too
complacent. But by the time the bear ends, all hope has been beaten
away. Pessimism and fear remain and traders are totally
demoralized.

It is actually
this excessive optimism that initially foments a bear. Near major
tops, stocks get bid up to prices far beyond what their earnings can
support. A bear is necessary to eradicate these
valuation
excesses. Over the course of a bear, valuations are slowly
eroded lower until stock prices are cheap relative to their earnings
near the end of a bear. So bears rebalance both sentiment and
valuations.

And while the
broad sweep of a bear is one giant slide from general greed to
general fear, there are smaller sentiment sub-cycles within its
duration. Traders get complacent after bear-market rallies, and
scared after bear-market downlegs. It is these mini-greed-fear
cycles within the longer greed-fear cycle of the entire bear that
can be so profitable to trade.

To trade a bear,
traders have to carefully monitor popular sentiment. And then when
it gets to an extreme, they must do the opposite of what
mainstream market thought considers right. When the thundering herd
is scared, traders want to go long and buy stocks. When the herd is
greedy or complacent, traders want to go short and sell stocks.
Contrarian trading within bears is dazzlingly effective.

While monitoring
consensus sentiment is something of an art form that comes with
market experience, there are some great tools available to get quick
reads. My personal favorite, and I believe the most effective,
sentiment gauge is the VXO implied volatility index. By carefully
studying and monitoring the VXO, traders can thrive in bear markets
by fading the majority at both greed and fear extremes.

While implied
volatility is mathematically intense, the basic concept is
straightforward. All day everyday, traders are gaming an uncertain
future via the stock-index options markets. Hedgers offload risk to
speculators, all parties making bets to try and maximize their
returns based on what each individual trader suspects is coming.
Collectively all these trades, the sum of every single active
trader’s own bias and outlook, feed into options pricing models.
The result is implied, or expected, volatility.

When traders get
scared, they expect more volatility ahead so their options trades
made in preparation drive implied volatility through the roof. When
traders get greedy or complacent, they expect smooth sailing and
their options trades reflect this. So implied volatility dries up.
It is really elegant conceptually, using existing trades to define
overall market expectations for near-future volatility.

How near? 30
days. The VXO calculates implied volatility for a synthetic,
at-the-money option on the S&P 100 index expiring 30 calendar days
out. If this sounds complicated, don’t worry. The thing to
internalize is a high VXO represents extreme general fear (the time
to buy) and a low VXO represents extreme general complacency (the
time to sell). The VXO effectively distills popular sentiment into
one number.

Before I get into
the mechanics of this, I have to digress briefly. The VXO is the
implied volatility index for the S&P 100 (the top 100 companies,
20%, of the SPX) but the VIX is the implied volatility index for the
S&P 500. So since everyone including me uses the SPX as the market
benchmark of choice, why not just use the VIX? While it certainly
can be used, I suspect the VXO is superior for a variety of reasons.

Until September
2003, the VIX used to apply to the S&P 100 (OEX). That month the
CBOE changed it to track the broader S&P 500. And not only did the
VIX’s mission change, but a new formula was introduced for its
calculation too. It incorporates a broader range of option strike
prices, with weightings increasing closer to at-the-money. So
today’s VIX is totally new since late 2003, not comparable with the
last bear’s.

To preserve the
true historical VIX, the CBOE renamed it the VXO. Thus the VXO was
battle-proven in the 2000-to-2002 bear (where it was called the VIX)
while today’s bear is the first the new VIX has ever seen. While
the VIX and VXO parallel each other closely most of the time, I like
the VXO’s proven track record. It is too bad the CBOE couldn’t have
named the new S&P 500 VIX something else instead.

And in bear
markets, when fear surges, institutional traders rush to liquidate
their biggest and most-liquid holdings to raise cash fast.
This is the elite S&P 100 companies. As of the end of June, this
top fifth of the S&P 500 accounted for 64.5% of its market
capitalization. This is a big majority, no doubt, but it still
means over one-third of the new VIX will be driven by stocks outside
of the base S&P 100.

Thus I suspect at
particularly ugly fear extremes, the VXO will decouple meaningfully
from the VIX for a few days. The VXO will go higher faster,
offering better trading signals. The top 20% of the SPX is just
vastly more liquid in panic situations than the entire index. Big
traders will dump OEX companies first as they have much higher
volumes and much larger market caps so fast selling will have less
of a price impact on any individual trader’s realized prices on
exit.

If my theory
proves right in this bear, the old-school hyper-liquid VXO will more
quickly and accurately reflect tradable fear excesses than the
somewhat-watered-down VIX. Until I see how the VIX does over an
entire cyclical bear, I’ll continue to watch the VXO that has proven
so useful in history. While I’ll write a whole essay on the VXO
versus VIX debate someday, that’s the nutshell version if you’re
curious.

Digression
complete, we can get into the actual bear-market trading mechanics.
This first chart overlays the SPX on the VXO during the 2000-to-2002
bear. While that bear technically bottomed in October 2002, it
retested those lows in March 2003. And that’s when the mighty
2003-to-2007 bull began. Since most analysts today consider March
2003 the end of the early-2000s bear, I ran this chart out to early
2003.

The obvious
inverse symmetry here is visually striking. During an in-progress
bear, traders watching the SPX always wonder whether the index
happens to be high enough for an interim top or low enough for an
interim bottom at any given time. Watching the VXO simultaneously
with the SPX helps resolve this conundrum. The VXO’s largely-fixed
range combined with its sentiment-mirroring nature shows when to buy
and sell in real-time.

Since bear markets
fall on balance, we’ll start on the short side. Note above that
each time the red VXO line headed into the low 20s the stock markets
soon started falling again. S&P 100 implied volatility around 20 or
lower signals either excessive greed or excessive complacency.
Neither can last long in an ongoing bear. A low VXO, defined as low
20s and lower, is one of the best bear-market shorting
signals.

Shorting
encompasses a variety of trading strategies. If you happen to have
long positions or call options still on the books from the preceding
bear-market rally, they should be liquidated on a short signal to
lock in your profits. New shorts or put options can also be added
ahead of the coming bear downleg. No matter how you do it, on a low
VXO extreme start positioning your capital to profit from market
downside.

As the downleg
foretold by the short signal matures, general fear really
ramps up. Short positions grow very profitable and fewer and fewer
traders want to try and “catch falling knives” and bet on a bounce.
With few buyers, stocks plunge. Eventually fear gets so extreme
that it becomes unbalanced and excessive. This is also reflected in
the VXO, which is why it is most commonly called a “fear gauge”.

Back in the
2000-to-2002 bear, VXO extremes marking unsustainable fear, and
hence an imminent sharp bear-market rally, gradually grew as the
bear matured. Early on in late 2000, the SPX could bounce off a VXO
peak in the upper 30s. By early 2001, this increased to 40ish
levels. And in later 2001 and 2002, the
fabled 50ish VXO
levels of yore were witnessed.

So whenever the
stock markets are falling fast and you are looking for a tradable
bear-market rally, watch the VXO. It should peak somewhere between
the upper 30s and 50 or so. That is when to close out all your
short-oriented positions and throw long via stock purchases and call
options. V-bounces within bears are driven by extreme fear, which
is only driven by sufficiently sharp stock plunges.

This was the
problem in the markets this week. As the SPX officially entered
bear territory a few days ago, traders were looking for a rally. By
itself, the SPX certainly did look oversold. It had fallen
12.8% on a closing basis in just 7 weeks! But fear wasn’t
excessive yet, the VXO was just nonchalantly meandering in the
mid-20s. In the last bear, how many major bear rallies launched
from such low fear levels? Zero.

Over the course of
an entire bear, stocks gradually drift lower on balance. But from a
tactical perspective, they bounce back and forth between greed and
fear. Traders cannot expect a major new downleg unless greed and
complacency are excessive. And they cannot expect a major new
bear-market rally unless fear gets excessive. Bears need to be
traded near these sentiment extremes, no other times are anywhere
near as optimal.

So waiting for
real fear, as reflected in the VXO, before closing shorts and adding
longs is critical. And this begs the vexing question. Should I
consider the upper 30s my long signal or should I hold out and wait
until 50? Unfortunately there is no clear-cut answer here, but I do
have a couple thoughts that have really helped my own trading.

First, realize
popular fear gradually grows over the course of a bear. Early on,
few people believe a bear is really upon them. Like the old
slowly-boiling-the-frog-to-keep-him-unaware proverb, bears
stealthily unfold so investors aren’t spooked too soon. And with
lower background fear earlier in bears, peak fear at extremes is
also lower. Thus I’d be more inclined to call the upper 30s my long
signal while this bear still remains young.

Later, as this
bear matures, both background fear and spike fear levels will
continue to ramp. So mid-bear I’ll be watching for the low 40s on
the VXO and by the last third of this bear (say spring to autumn
2009 or so) we’ll almost certainly see VXO 50 again. As general
fear grows, the VXO level at which a strong long signal can be
declared will rise as well.

Second, greed and
fear run along a continuum. Sometimes major trend reversals (from
downleg to bear rally or vice versa) can happen at lower emotional
intensities than usual. So hard-and-fast VXO targets, on both the
upside and downside, are problematic. Instead, think in terms of a
probability scale. The higher the VXO, the better your odds for
success with longs. The lower, the better your odds with shorts.

So actual entry
points can be scaled in and gamed a bit. If the VXO hits the upper
30s, close some shorts and add some longs. If it goes higher still
after that (meaning the SPX fell farther), add more long positions.
But once it gets to 50, even if only for a moment, it is time to
throw long aggressively and close out all shorts. Historically the
VXO rarely exceeds 50 and if it does it is for an exceedingly-short
period of time. VXO 50 is as close to an absolute fear top as you
can get.

Also realize that
fear extremes heralding a V-bounce and major bear rally can happen
anytime during the trading day. If fear peaks at noon, and no one
is left to sell, the VXO will also peak at noon. Thus the intraday
VXO high can be significantly higher than the closing VXO level.
While these charts in this essay show VXO closes, at every extreme I
noted two numbers. The lower one is the VXO close that day while
the upper one is the intraday VXO high. They are both worth
pondering.

The practical
application for traders here is this. Once the VXO gets to 35 or
so, start watching the darned thing religiously, every minute of
every day. Odds are the actual fear peak, and hence tradable
stock-market bottom, is not going to happen conveniently right at
the end of a trading day. Another clue the bottom has arrived in
real-time is stocks are in a free-fall and the CNBC talking heads
are very frightened. After you see a few bottoms unfold, you’ll
know just what to look for.

All these lessons
from the last bear can be applied to our current bear. While young,
the VXO and SPX are already behaving very similarly to the ways they
did early on in the early-2000s bear. I rendered this chart
of our current bear at the same vertical scales as the previous one
for comparability. Stocks are falling while both background fear
and spike fear are gradually ramping. Welcome to the bear market!

Back in early
October when the SPX bull finally gave up its ghost, the VXO fell to
15. These are very low levels showing extreme greed and
complacency. But back then of course the cyclical bull had not yet
failed. Low implied volatility levels are common late in bull
markets as fear is long-forgotten. By late 2007 it had been five
years since we’d seen a sharp selloff and fear-driven VXO spike!

But as 2008
dawned, increasing signs of a new bear market emerged. In January
2008, I wrote about the increasing odds for an
impending
cyclical bear based on
Long Valuation
Waves. After the March lows, we were riding the SPX bear rally
higher in commodities stocks. But by early June, it was once again
apparent that a
new bear downleg was upon us. It has really accelerated in the
past month.

So far in our
young bear, we’ve only seen one full bear downleg (October 2007 to
March 2008) and one full bear rally (March 2008 to May 2008). Since
then, we’ve entered this bear’s second major downleg. With this
structural perspective of the ongoing SPX bear in mind, the VXO’s
behavior is very interesting and nicely echoes its famous
characteristics of the past.

At the peak in
October, greed was high and the VXO was very low. This was a great
time to short with such abnormally-low implied volatility, even in a
bull. While stocks soon started sliding, they really accelerated
into January. Fears grew pretty intense for a spell. The January
VXO peak on a closing basis was 33, not high. But intraday it
approached 39, which is much more typical of an early-bear tradable
bounce.

The SPX did indeed
bounce, but failed to enter a full-blown bear rally. By March it
was plumbing new lows that saw VXO tops of 34 closing and 37
intraday. Probably because fear wasn’t too particularly extreme
here, the subsequent bear rally wasn’t all that impressive either.
It only ran 12.0% higher from March to May, well under the 20.5%
average for major bear rallies in 2001 and 2002. Of course that
bear was more mature by those years than our cub today, which might
help explain this.

But when the VXO
again started falling under 20, and ultimately under 15 briefly in
May, it was clear the bear rally was running out of steam. A new
downleg was being born. So even in the young bear since October,
using the VXO as a fear gauge to game major interim reversals has
been quite profitable. I’ve talked about each reversal as it
happened in our newsletters, and the VXO level was always a major
clue. Watch the VXO closely, shorting at low levels and buying at
high levels.

So trading bears
is indeed possible, and quite profitable. And today it is easier
than ever thanks to the proliferation of new ETF-like trading
vehicles. Now stock traders can short stock indexes, and sectors,
with leverage in some cases, directly out of normal stock trading
accounts by buying ETFs. This is a vast improvement from the last
bear when all we had was outright shorting and put options.

In the new July
issue of our monthly
Zeal Intelligence
newsletter, I discussed many of these new bear-trading vehicles.
You’d be amazed at all the neat new ways to game short-side
exposure! I also discussed some of the reasons why this bear is
likely to persist for at least another year or so, granting plenty
of downlegs and bear rallies to trade.
Subscribe today,
join us in thriving through a difficult bear environment that
crushes normal investors.

The bottom line is
we are officially in a new SPX bear, and it remains quite young.
While bears slaughter buy-and-holders, they offer outstanding
trading opportunities. Prudent and disciplined contrarian traders
who can buy when everyone else is scared and sell when they are not
can earn fortunes over the course of a bear. The
greed-fear-greed-fear downleg-rally-downleg-rally cycle is really
fun to trade.

And the implied
volatility indexes, particularly the classic VXO, are the best
one-stop proxies for general greed and fear levels. The higher the
VXO (fear), the higher the odds for success in new long trades. The
lower the VXO, the higher the odds for success in new short trades.
And this holds true regardless of where the SPX happens to be
trading on any particular day.